Phillips Curve

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Inflation and Unemployment: A Layperson’s Guide to the Phillips Curve

by Jeffrey M. Lacker and John A. Weinberg

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What do you remember from the economics class you took in college? Even if you didn’t take economics, what basic ideas do you think are important for understanding the way markets work? In either case, one thing you might come up with is that when the demand for a good rises—when more and more people want more and more of that good—its price will tend to increase. This basic piece of economic logic helps us understand the phenomena we observe in many specific markets—from the tendency of gasoline prices to rise as the summer sets in and people hit the road on their family vacations, to the tendency for last year’s styles to fall in price as consumers turn to the new fashions. This notion paints a picture of the price of a good moving together in the same direction with its quantity—when people are buying more, its price is rising. Of course supply matters, too, and thinking about variations in supply—goods becoming more or less plentiful or more or less costly to produce—complicates the picture. But in many cases such as the examples above, we might expect movements up and down in demand to happen more frequently than movements in supply. Certainly for goods produced by a stable industry in an environment of little technological change, we would expect that many movements in price and quantity are driven by movements in demand, which would cause price and quantity to move up and down together. Common sense suggests that this logic would carry over to how one thinks about not only the price of one good but also the prices of all goods. Should an average measure of all prices in the economy—the consumer price index, for example—be expected to move up when our total measures of goods produced and consumed rise? And should faster growth in these quantities—as measured, say, by gross domestic product—be accompanied by faster increases in prices? That is, should inflation move up and down with real economic growth?

The authors are respectively President and Senior Vice President and Director of Research. The views expressed are the authors’ and not necessarily those of the Federal Reserve System.

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The simple intuition behind this series of questions

all goods—that is, rising aggregate demand—would

is seriously incomplete as a description of the behav-

not make all prices rise. Rather, the important impli-

ior of prices and quantities at the macroeconomic

cation of this distinction is that it focuses attention on

level. But it does form the basis for an idea at the

what, besides people’s underlying desire for more

heart of much macroeconomic policy analysis for at

goods and services, might drive a general increase in

least a half century. This idea is called the “Phillips

all prices. The other key factor is the supply of money

curve,” and it embodies a hypothesis about the rela-

in the economy.

tionship between inflation and real economic vari-

Economic decisions of producers and consumers

ables. It is usually stated not in terms of the positive

are driven by relative prices: a rising price of bagels

relationship between inflation and growth but in terms

relative to doughnuts might prompt a baker to shift

of a negative relationship between inflation and

production away from doughnuts and toward bagels. If we could imagine a situation in which all prices of

“ This idea is called the ‘Phillips curve,’ and it

all outputs and inputs in the economy, including

embodies a hypothesis about the relationship

wages, rise at exactly the same rate, what effect on

between inflation and real economic variables. It

economic decisions would we expect? A reasonable

is usually stated. . . in terms of a negative relation-

answer is “none.” Nothing will have become more

ship between inflation and unemployment. ”

expensive relative to other goods, and labor income will have risen as much as prices, leaving people no

unemployment. Since faster growth often means more intensive utilization of an economy’s resources,

poorer or richer. The thought experiment involving all prices and

faster growth will be expected to come with falling

wages rising in equal proportions demonstrates the

unemployment. Hence, faster inflation is associated

principle of monetary neutrality. The term refers to the

with lower unemployment. In this form, the Phillips

fact that the hypothetical increase in prices and wages

curve looks like the expression of a trade-off between

could be expected to result from a corresponding

two bad economic outcomes—reducing inflation

increase in the supply of money. Monetary neutrality

requires accepting higher unemployment.

is a natural starting point for thinking about the

The first important observation about this relation-

relationship between inflation and real economic

ship is that the simple intuition described at the begin-

variables. If money is neutral, then an increase in the

ning of this essay is not immediately applicable at the

supply of money translates directly into inflation and

level of the economy-wide price level. That intuition is

has no necessary relationship with changes in real

built on the workings of supply and demand in setting

output, output growth, or unemployment. That is,

the quantity and price of a specific good. The price

when money is neutral, the simple supply-and-

of that specific good is best understood as a relative

demand intuition about output growth and inflation

price—the price of that good compared to the prices

does not apply to inflation associated with the growth

of other goods. By contrast, inflation is the rate of

of the money supply.

change of the general level of all prices. Recognizing this distinction does not mean that rising demand for

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The logic of monetary neutrality is indisputable, but is it relevant? The logic arises from thinking about

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hypothetical “frictionless” economies in which all mar-

is by no means exhaustive. Important parts of econ-

ket participants at all times have all the information

omists’ understanding of this relationship that we neg-

they need to price the goods they sell and to choose

lect include discussions of how the observed Phillips

among the available goods, and in which sellers can

curve’s statistical relationship could emerge even

easily change the price they charge. Against this

under monetary neutrality.1 We also neglect the liter-

hypothetical benchmark, actual economies are likely

ature on the possibility of real economic costs of

to appear imperfect to the naked eye. And under the

inflation that arise even when money is neutral.2

microscope of econometric evidence, a positive corre-

Instead, we seek to provide the broad outlines of the

lation between inflation and real growth does tend to

intellectual development that has led to the role of

show up. The task of modern macroeconomics has

the Phillips curve in modern macroeconomics,

been to understand these empirical relationships.

emphasizing the interplay of economic theory and

What are the “frictions” that impede monetary neu-

empirical evidence.

trality? Since monetary policy is a key determinant of

After reviewing the history, we will turn to the cur-

inflation, another important question is how the con-

rent debate about the Phillips curve and how it trans-

duct of policy affects the observed relationships. And

lates into differing views about monetary policy.

finally, what does our understanding of these relation-

People commonly talk about a central bank seeking

ships imply about the proper conduct of policy?

to engineer a slowing of the economy to bring about

The Phillips curve, viewed as a way of capturing

lower inflation. They think of the Phillips curve as

how money might not be neutral, has always been a

describing how much slowing is required to achieve a

central part of the way economists have thought

given reduction in inflation. We believe that this read-

about macroeconomics and monetary policy. It also

ing of the Phillips curve as a lever that a policymaker

forms the basis, perhaps implicitly, of popular under-

might manipulate mechanically can be misleading. By

standing of the basic problem of economic policy:

itself, the Phillips curve is a statistical relationship that

namely, we want the economy to grow and unem-

has arisen from the complex interaction of policy deci-

ployment to be low, but if growth is too robust,

sions and the actions of private participants in the

inflation becomes a risk. Over time, many debates

economy. Importantly, choices made by policymakers

about economic policy have boiled down to alterna-

play a large role in determining the nature of the sta-

tive understandings of what the Phillips curve is and

tistical Phillips curve. Understanding that relation-

what it means. Even today, views that economists

ship—between policymaking and the Phillips curve—

express on the effects of macroeconomic policy in

is a key ingredient to sound policy decisions. We

general and monetary policy in particular often derive

return to this theme after our historical overview.

from what they think about the nature, the shape, and the stability of the Phillips curve.

Some History

This essay seeks to trace the evolution of our

The Phillips curve is named for New Zealand-born

understanding of the Phillips curve, from before its

economist A. W. Phillips, who published a paper in

inception to contemporary debates about economic

1958 showing an inverse relationship between (wage)

policy. The history presented in the pages that follow

inflation and unemployment in nearly 100 years of

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data from the United Kingdom.3 Since this is the work

ultimately, this would merely amount to a change in

from which the curve acquired its name, one might

units of measurement. Given enough time for the

assume that the economics profession’s prior consen-

extra money to spread itself throughout the economy,

sus on the matter embodied the presumption that

all prices would rise proportionately. So while the

money is neutral. But this in fact is not the case.

number of units of money needed to compensate a

The idea of monetary neutrality has long coexisted

day’s labor might be higher, the amount of food,

with the notion that periods of rising money growth

shelter, and clothing that a day’s pay could purchase

and inflation might be accompanied by increases in

would be exactly the same as before the increase in

output and declines in unemployment. Robert Lucas

money and prices.

(1996), in his Nobel lecture on the subject of mone-

Against this logic stood the classical economists’

tary neutrality, finds both ideas expressed in the work

observations of the world around them in which

of David Hume in 1752! Thomas Humphrey (1991)

increases in money and prices appeared to bring

traces the notion of a Phillips curve trade-off through-

increases in industrial and commercial activity. This

out the writings of the classical economists in the

empirical observation did not employ the kind of

eighteenth and nineteenth centuries. Even Irving

formal statistics as that used by modern economists

Fisher, whose statement of the quantity theory of

but simply the practice of keen observation. They

money embodied a full articulation of the conse-

would typically explain the difference between their

quences of neutrality, recognized the possible real

theory’s predictions (neutrality) and their observations

effects of money and inflation over the course of a

by appealing to what economists today would call

business cycle.

“frictions” in the marketplace. Of particular importance

In early writings, these two opposing ideas—that

in this instance are frictions that get in the way of

money is neutral and that it is associated with rising

price adjustment or make it hard for buyers and sell-

real growth—were typically reconciled by the distinc-

ers of goods and services to know when the general

tion between periods of time ambiguously referred to

level of all prices is rising. If a craftsman sees that he

as “short-run” and “long-run.” The logic of monetary

can sell his wares for an increased price but doesn’t realize that all prices are rising proportionately, he

“ In early writings, these two opposing ideas—

might think that his goods are rising in value relative

that money is neutral and that it is associated

to other goods. He might then take action to increase

with rising real growth—were typically recon-

his output so as to benefit from the perceived rise in

ciled by the distinction between periods of

the worth of his labors.

time ambiguously referred to as ‘short-run’ and ‘long-run.’ ”

This example shows how frictions in price adjustment can break the logic of money neutrality. But such a departure is likely to be only temporary. You

neutrality is essentially long-run logic. The type of

can’t fool everybody forever, and eventually people

thought experiment the classical writers had in mind

learn about the general inflation caused by an increase

was a one-time increase in the quantity of money

in money. The real effects of inflation should then

circulating in an economy. Their logic implied that,

die out. It was in fact in the context of this distinction

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between long-run neutrality and the short-run trade-off between inflation and real growth that John Maynard Keynes made his oft-quoted quip that “in the long run we are all dead.”4 Phillips’ work was among the first formal statistical analyses of the relationship between inflation and real economic activity. The data on the rate of wage increase and the rate of unemployment for Phillips’ baseline period of 1861–1913 are reproduced in Figure 1. These data show a clear negative relationship—greater inflation tends to coincide with lower

Figure 1: Inflation-Unemployment Relationship in the United Kingdom, 1861-1913 10 RATE OF CHANGE OF WAGE RATE (% PER YEAR)

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8 6 4 2 0

-2

-4

0

1

2

3

4 5 6 7 8 UNEMPLOYMENT RATE (%)

9

10

11

Source: Phillips (1958)

unemployment. To highlight that relationship, Phillips fit the curve in Figure 1 to the data. He then examined a

about 5 1⁄2 percent. To achieve unemployment of about

number of episodes, both within the baseline period

3 percent, which the authors viewed as approximately

and in other periods up through 1957. The general

full employment, the curve suggests that inflation

tendency of a negative relationship persists throughout.

would need to be close to 5 percent. Samuelson and Solow did not propose that their

Crossing the Atlantic

estimated curve described a permanent relationship

A few years later, Paul Samuelson and Robert Solow,

that would never change. Rather, they presented it as

both eventual Nobel Prize winners, took a look at the

a description of the array of possibilities facing the

U.S. data from the beginning of the twentieth century

economy in “the years just ahead.”6 While recogniz-

through 1958.5 A similar scatter-plot to that in Figure 1

ing that the relationship might change beyond this

was less definitive in showing the negative relation-

near horizon, they remained largely agnostic on how

ship between wage inflation and unemployment.

and why it might change. As a final note, however,

The authors were able to recover a pattern similar to

they suggest institutional reforms that might produce

Phillips’ by taking out the years of the World Wars and

a more favorable trade-off (shifting the curve in

the Great Depression. They also translated their find-

Figure 2 down and to the left). These involve meas-

ings into a relationship between unemployment and

ures to limit the ability of businesses and unions to

price inflation. It is this relationship that economists

exercise monopoly control over prices and wages, or

now most commonly think of as the “Phillips curve.”

even direct wage and price controls. Their closing

Samuelson and Solow’s Phillips curve is repro-

discussion suggests that they, like many economists

duced in Figure 2. (See page 10.) They interpret this

at the time, viewed both inflation and the frictions

curve as showing the combinations of unemployment

that kept money and inflation from being neutral

and inflation available to society. The implication is

as at least partly structural—hard-wired into the

that policymakers must choose from the menu traced

institutions of modern, corporate capitalism. Indeed,

out by the curve. An inflation rate of zero, or price sta-

they concluded their paper with speculation about

bility, appears to require an unemployment rate of

institutional reforms that could move the Phillips curve

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down and to the left. This was an interpretation that

Turning the focus to expectations

was compatible with the idea of a more permanent

This approach to economic policy implicitly either

trade-off that derived from the structure of the

denied the long-run neutrality of money or thought it irrelevant. A distinct minority view within the profes-

Figure 2: Inflation-Unemployment Relationship in the United States around 1960 AVERAGE INCREASE IN PRICE (% PER YEAR)

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sion, however, continued to emphasize limitations

11

on the ability of rising inflation to bring down unem-

10

ployment in a sustained way. The leading proponent

9 8

of this view was Milton Friedman, whose Nobel

7

Prize award would cite his Phillips curve work. In

6 5

his presidential address to the American Economics

B

4

Association, Friedman began his discussion of mone-

3

tary policy by stipulating what monetary policy cannot

2 1 -1

do. Chief among these was that it could not “peg

A

0

the rate of unemployment for more than very limited 1

2

3

4

5

6

7

8

9

UNEMPLOYMENT RATE (%) Source: Samuelson and Solow (1960)

periods.”7 Attempts to use expansionary monetary policy to keep unemployment persistently below what he referred to as its “natural rate” would inevitably

economy and that could be exploited by policymakers

come at the cost of successively higher inflation.

seeking to engineer lasting changes in economic

Key to his argument was the distinction between

performance.

anticipated and unanticipated inflation. The short-run

By the 1960s, then, the Phillips curve trade-off had

trade-off between inflation and unemployment

become an essential part of the Keynesian approach

depended on the inflation expectations of the public.

to macroeconomics that dominated the field in the

If people generally expected price stability (zero

decades following the Second World War. Guided by

inflation), then monetary policy that brought about

this relationship, economists argued that the govern-

inflation of 3 percent would stimulate the economy,

ment could use fiscal policy—government spending

raising output growth and reducing unemployment.

or tax cuts—to stimulate the economy toward full

But suppose the economy had been experiencing

employment with a fair amount of certainty about

higher inflation, of say 5 percent, for some time,

what the cost would be in terms of increased inflation.

and that people had come to expect that rate of

Alternatively, such a stimulative effect could be

increase to continue. Then, a policy that brought

achieved by monetary policy. In either case, policy-

about 3 percent inflation would actually slow the

making would be a conceptually simple matter of

economy, making unemployment tend to rise.

cost-benefit analysis, although its implementation

By emphasizing the public’s inflation expectations,

was by no means simple. And since the costs of a

Friedman’s analysis drew a link that was largely

small amount of inflation to society were thought

absent in earlier Phillips curve analyses. Specifically,

to be low, it seemed worthwhile to achieve a lower

his argument was that not only is monetary policy pri-

unemployment rate at the cost of tolerating only a

marily responsible for determining the rate of inflation

little more inflation.

that will prevail, but it also ultimately determines the

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location of the entire Phillips curve. He argued that

the natural rate of unemployment is 5 percent and

the economy would be at the natural rate of unem-

people initially expect inflation of 1 percent. A surprise

ployment in the absence of unanticipated inflation.

inflation of 3 percent drives unemployment down to

That is, the ability of a small increase in inflation to

3 percent. But sustained inflation at the higher rate

stimulate economic output and employment relied on

ultimately changes expectations, and the Phillips curve

the element of surprise. Both the inflation that people

shifts back so that the natural rate of unemployment

had come to expect and the ability to create a surprise

is achieved but now at 3 percent inflation. This analy-

were then consequences of monetary policy decisions.

sis, which takes account of inflation expectations, is

Friedman’s argument involved the idea of a “natural

referred to as the expectations-augmented Phillips

rate” of unemployment. This natural rate was some-

curve. An independent and contemporaneous devel-

thing that was determined by the structure of the

opment of this approach to the Phillips curve was

economy, its rate of growth, and other real factors

given by Edmund Phelps, winner of the 2006 Nobel

independent of monetary policy and the rate of infla-

Prize in economics.8 Phelps developed his version of

tion. While this natural rate might change over time,

the Phillips curve by working through the implications

at any point in time, unemployment below the natural

of frictions in the setting of wages and prices, which

rate could only be achieved by policies that created

anticipated much of the work that followed.

inflation in excess of that anticipated by the public.

The reasoning of Friedman and Phelps implied that

But if inflation remained at the elevated level, people

attempts to exploit systematically the Phillips curve to

would come to expect higher inflation, and its stimula-

bring about lower unemployment would succeed only

tive effect would be lost. Unemployment would move

temporarily at best. To have an effect on real activity,

back toward its natural rate. That is, the Phillips curve

monetary policy needed to bring about inflation in

would shift up and to its right, as shown in Figure 3.

excess of people’s expectations. But eventually,

The figure shows a hypothetical example in which Figure 3: Expectations-Augmented Phillips Curve

people would come to expect higher inflation, and the policy would lose its stimulative effect. This insight comes from an assumption that people base their

8

expectations of inflation on their observation of past

7 INFLATION RATE (%)

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inflation. If, instead, people are more forward looking

6

and understand what the policymaker is trying to do,

5

they might adjust their expectations more quickly,

4

causing the rise in inflation to lose much of even its

3

temporary effect on real activity. In a sense, even the

2

short-run relationship relied on people being fooled.

1

One way people might be fooled is if they are simply 1

2

3

4

5

u*

6

7

8

UNEMPLOYMENT RATE (%) Note: When expected inflation is 1 percent, an unanticipated increase in inflation will initially bring unemployment down. But expectations will eventually adjust, bringing unemployment back to its natural rate (u*) at the higher rate of inflation.

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unable to distinguish general inflation from a change in relative prices. This confusion, sometimes referred to as money illusion, could cause people to react to inflation as if it were a change in relative prices. For

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Figure 4: Inflation-Unemployment Relationship in the United States,1961-1995

instance, workers, seeing their nominal wages rise but not recognizing that a general inflation is in

14

process, might react as if their real income were ris-

12

ing. That is, they might increase their expenditures on goods and services. Robert Lucas, another Nobel Laureate, demonstrated how behavior resembling money illusion could result

INFLATION RATE (%)

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10 8

the difference between relative prices and the general

0

people’s misunderstanding, but from their inability to

70

4 2

75

90

6

even with firms and consumers who fully understood price level.9 In his analysis, confusion comes not from

80

85 65 3

4

95 61 5 7 6 UNEMPLOYMENT RATE (%)

8

9

10

Sources: Bureau of Labor Statistics/Haver Analytics Note: Inflation rate is seasonally-adjusted CPI, Fourth Quarter.

observe all of the economy’s prices at one time. His was the first formal analysis showing how a Phillips

writers appeared to break down entirely, as shown by

curve relationship could emerge in an economy with

the scatter plot of the data for the 1970s in Figure 4.

forward-looking decisionmakers. Like the work of

Throughout this decade, both inflation and unemploy-

Friedman and Phelps, Lucas’ implications for policy-

ment tended to grow, leading to the emergence of the term “stagflation” in the popular lexicon.

“ The reasoning of Friedman and Phelps implied

One possible explanation for the experience of the

that attempts to exploit systematically the

1970s is that the decade was simply a case of bad

Phillips curve to bring about lower unemploy-

luck. The Phillips curve shifted about unpredictably as

ment would succeed only temporarily at best. ”

the economy was battered by various external shocks. The most notable of these shocks were the dramatic

makers were cautionary. The relationship between

increases in energy prices in 1973 and again later in

inflation and real activity in his analysis emerged

the decade. Such supply shocks worsened the avail-

most strongly when policy was conducted in an

able trade-off, making higher unemployment neces-

unpredictable fashion, that is, when policymaking

sary at any given level of inflation.

was more a source of volatility than stability.

By contrast, viewing the decade through the lens of the expectations-augmented Phillips curve suggests

The Great Inflation

that policy shared the blame for the disappointing

The expectations-augmented Phillips curve had the

results. Policymakers attempted to shield the real

stark implication that any attempt to utilize the rela-

economy from the effects of aggregate shocks. Guided

tionship between inflation and real activity to engineer

by the Phillips curve, this effort often implied a choice

persistently low unemployment at the cost of a little

to tolerate higher inflation rather than allowing unem-

more inflation was doomed to failure. The experience

ployment to rise. This type of policy choice follows

of the 1970s is widely taken to be a confirmation of

from viewing the statistical relationship Phillips first

this hypothesis. The historical relationship identified

found in the data as a menu of policy options, as

by Phillips, Samuelson and Solow, and other earlier

suggested by Samuelson and Solow. But the

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arguments made by Friedman and Phelps imply that

played against a public that is trying to anticipate

such a trade-off is short-lived at best. Unemployment

policy. What’s more, this game is repeated over and

would ultimately return to its natural rate at the higher

over, each time a policy choice must be made. This

rate of inflation. So, while the relative importance of

complicated interdependence of policy choices and

luck and policy for the poor macroeconomic perform-

private sector actions and expectations was studied

ance of the 1970s continues to be debated by econo-

by Finn Kydland and Edward C. Prescott.12 In one

mists, we find a powerful lesson in the history of that

of the papers for which they were awarded the 2005

decade.10 The macroeconomic performance of the

Nobel Prize, they distinguish between rules and

1970s is largely what the expectations-augmented

discretion as approaches to policymaking. By discre-

Phillips curve predicts when policymakers try to exploit

tion, they mean period-by-period decisionmaking in

a trade-off that they mistakenly believe to be stable.

which the policymaker takes a fresh look at the costs

The insights of Friedman, Phelps, and Lucas pointed

and benefits of alternative inflation levels at each

to the complicated interaction between policymaking

moment. They contrast this with a setting in which

and statistical analysis. Relationships we observe in

the policymaker makes a one-time decision about the

past data were influenced by past policy. When policy

best rule to guide policy. They show that discretionary

changes, people’s behavior may change and so too

policy would result in higher inflation and no lower

may statistical relationships. Hence, the history of the

unemployment than the once-and-for-all choice of

1970s can be read as an illustration of Lucas’ critique

a policy rule.

of what was at the time the consensus approach to policy analysis.11 Focusing attention on the role of expectations in the

Recent work by Thomas Sargent and various coauthors shows how discretionary policy, as studied by Kydland and Prescott, can lead to the type of inflation

Phillips curve creates a challenge for policymakers

outcomes experienced in the 1970s.13 This analysis

seeking to use monetary policy to manage real eco-

assumes that the policymaker is uncertain of the

nomic activity. At any point in time, the current state

position of the Phillips curve. In the face of this un-

of the economy and the private sector’s expectations

certainty, the policymaker estimates a Phillips curve from historical data. Seeking to exploit a short-run,

“ Focusing attention on the role of expecta-

expectations-augmented Phillips curve—that is, pur-

tions in the Phillips curve creates a challenge

suing discretionary policy—the policymaker chooses

for policymakers seeking to use monetary

among inflation-unemployment combinations described

policy to manage real economic activity. ”

by the estimated Phillips curve. But the policy choices themselves cause people’s beliefs about policy to

may imply a particular Phillips curve. Assuming that

change, which causes the response to policy choices

Phillips curve describes a stable relationship, a policy-

to change. Consequently, when the policymaker uses

maker might choose a preferred inflation-unemploy-

new data to update the estimated Phillips curve, the

ment combination. That very choice, however, can

curve will have shifted. This process of making policy

alter expectations, causing the trade-off to change.

while also trying to learn about the location of the

The policymaker’s problem is, in effect, a game

Phillips curve can lead a policymaker to choices that

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result in persistently high inflation outcomes. In addition to the joint rise in inflation and unem-

cost, but it is substantially less than many had predicted before the fact. Again, one possible reason

ployment during the 1970s, other empirical evidence

could be that the Fed’s course of action in this

pointed to the importance of expectations. Sargent

episode became well-anticipated once it commenced.

studied the experience of countries that had suffered

While the public might not have known the extent of

from very high

inflation.14

In countries where mone-

the actions the Fed would take, the direction of the

tary reforms brought about sudden and rapid deceler-

change in policy may well have become widely

ations in inflation, he found that the cost in terms of

understood. By the same token, and as argued by

reduced output or increased unemployment tended to

Goodfriend and King, remaining uncertainty about how

be much lower than standard Phillips curve trade-offs

far and how persistently the Fed would bring inflation

would suggest. One interpretation of these findings is

down may have resulted in the costs of disinflation

that the disinflationary policies undertaken tended to

being greater than they might otherwise have been.

be well-anticipated. Policymakers managed to credi-

The experience of the 1970s, together with the

bly convince the public that they would pursue these

insights of economists emphasizing expectations,

policies. Falling inflation that did not come as a sur-

ultimately brought the credibility of monetary policy

prise did not have large real economic costs.

to the forefront in thinking about the relationship

On a smaller scale in terms of peak inflation rates,

between inflation and the real economy. Credibility

another exercise in dramatic disinflation was conduct-

refers to the extent to which the central bank can con-

ed by the Federal Reserve under Chairman Paul

vince the public of its intention with regard to inflation.

Volcker.15 As inflation rose to double-digit levels in the

Kydland and Prescott showed that credibility does not

late 1970s, contemporaneous estimates of the cost in unemployment and lost output that would be neces-

“ The experience of the 1970s, together with

sary to bring inflation down substantially were quite

the insights of economists emphasizing expec-

large. A common range of estimates was that the

tations, ultimately brought the credibility of

6 percentage-point reduction in inflation that was

monetary policy to the forefront in thinking

ultimately brought about would require output from

about . . . inflation and the real economy. ”

9 to 27 percent below capacity annually for up to four years.16 Beginning in October 1979, the Fed took

come for free. There is always a short-run gain from

drastic steps, raising the federal funds rate as high

allowing inflation to rise a little so as to stimulate the

as 19 percent in 1980. The result was a steep, but

real economy. To establish credibility for a low rate of

short recession. Overall, the costs of the Volcker

inflation, the central bank must convince the public

disinflation appear to have been smaller than had

that it will not pursue that short-run gain.

been expected. A standard estimate, which appears

The experience of the 1980s and 1990s can be

in a popular economics textbook, is one in which the

read as an exercise in building credibility. In several

reduction in output during the Volcker disinflation

episodes during that period, inflation expectations

amounted to less than a 4 percent annual shortfall

rose as doubts were raised about the Fed’s ability to

relative to

capacity.17

This amount is a significant

maintain its commitment to low inflation. These

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episodes, labeled inflation scares by Marvin Goodfriend, were marked by rapidly rising spreads

Deriving a Phillips curve from price-setting behavior

between long-term and short-term interest rates.18

This price-setting friction has become a popular

Goodfriend identifies inflation scares in 1980, 1983,

device for economists seeking to model the behavior

and 1987. These tended to come during or following

of economies with a short-run Phillips curve. To see

episodes in which the Fed responded to real economic

how such a friction leads to a Phillips curve, think

weakness with reductions (or delayed increases) in its

about a business that is setting a price for its product

federal funds rate target. In these instances, Fed policy-

and does not expect to get around to setting the price

makers reacted to signs of rising inflation expectations

again for some time. Typically, the business will

by raising interest rates. These systematic policy re-

choose a price based on its own costs of production

sponses in the 1980s and 1990s were an important part

and the demand that it faces for its goods. But

of the process of building credibility for lower inflation.

because that business expects its price to be fixed for a while, its price choice will also depend on what

The “Modern” Phillips Curve

it expects to happen to its costs and its demand

The history of the Phillips curve shows that the empir-

between when it sets its price this time and when it

ical relationship shifts over time, and there is evi-

sets its price the next time.

dence that those movements are linked to the public’s

If the price-setting business thinks that inflation will

inflation expectations. But what does the history say

be high in the interim between its price adjustments,

about why this relationship exists? Why is it that there

then it will expect its relative price to fall. As average

is a statistical relationship between inflation and real

prices continue to rise, a good with a temporarily

economic activity, even in the short run? The earliest

fixed price gets cheaper. The firm will naturally be

writers and those that followed them recognized that

interested in its average relative price during the peri-

the short-run trade-off must arise from frictions that

od that its price remains fixed. The higher the inflation

stand in the way of monetary neutrality. There are

expected by the firm up until its next price adjustment,

many possible sources of such frictions. They may

the higher the current price it will set. This reasoning,

arise from the limited nature of the information individ-

applied to all the economy’s sellers of goods and serv-

uals have about the full array of prices for all products

ices, leads directly to a close relationship between

in the economy, as emphasized by Lucas. Frictions

current inflation and expected future inflation.

might also stem from the fact that not all people par-

This description of price-setting behavior implies

ticipate in all markets, so that different markets might

that current inflation depends on the real costs of

be affected differently by changes in monetary policy.

production and expected future inflation. The real

One simple type of friction is a limitation on the flexi-

costs of production for businesses will rise when the

bility sellers have in adjusting the prices of the goods

aggregate use of productive resources rises, for

they sell. If there are no limitations all prices can

instance because rising demand for labor pushes up

adjust seamlessly whenever demand or cost condi-

real wages.19 The result is a Phillips curve relationship

tions change, then a change in monetary policy will,

between inflation and a measure of real economic

again, affect different markets differently.

activity, such as output growth or unemployment.

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Current inflation rises with expected future inflation

holds’ and business’ decisions about consumption

and falls as current unemployment rises relative to its

and investment. These decisions involve people’s

“natural” rate (or as current output falls relative to the

demand for resources now, as compared to their

trend rate of output growth).

expected demand in the future. Their willingness to trade off between the present and the future depends

A Phillips curve in a “complete” modern model

on the price of that trade-off—the real rate of interest.

The price-setting frictions that are part of many mod-

One source of interdependence between different

ern macroeconomic models are really not that differ-

parts of the model—different equations—is in the real

ent from arguments that economists have always

rate of interest. A real rate is a nominal rate—the

made about reasons for the short-run non-neutrality

interest rates we actually observe in financial mar-

of money. What distinguishes the modern approach is

kets—adjusted for expected inflation. Real rates

not just the more formal, mathematical derivation of a

are what really matter for households’ and firms’

Phillips curve relationship, but more importantly, the

decisions. So on the demand side of the economy,

incorporation of this relationship into a complete

people’s choices about consumption and investment

model of the macroeconomy. The word “complete”

depend on what they expect for inflation, which comes,

here has a very specific meaning, referring to what

in part, from the pricing behavior described by the

economists call “general equilibrium.” The general

Phillips curve. Another source of interdependence

equilibrium approach to studying economic activity

comes in the way the central bank influences nominal

recognizes the interdependence of disparate parts of

interest rates by setting the rate charged on overnight,

the economy and emphasizes that all macroeconomic

interbank loans (the federal funds rate in the United

variables such as GDP, the level of prices, and

States). A complete model also requires a description

unemployment are all determined by fundamental

of how the central bank changes its nominal interest

economic forces acting at the level of individual

rate target in response to changing economic con-

households and businesses. The completeness of a

ditions (such as inflation, growth, or unemployment).

general equilibrium model also allows for an analysis

In a complete general equilibrium analysis of an

of the effects of alternative approaches to macroeco-

economy’s performance, all three parts—the Phillips

nomic policy, as well as an evaluation of the relative

curve, the demand side, and central bank behavior—

merits of alternative policies in terms of their effects on

work together to determine the evolution of economic

the economic well-being of the people in the economy.

variables. But many of the economic choices people

The Phillips curve is only one part of a complete

make on a day-to-day basis depend not only on con-

macroeconomic model—one equation in a system

ditions today, but also on how conditions are expected

of equations. Another key component describes

to change in the future. Such expectations in modern

how real economic activity depends on real interest

macroeconomic models are commonly described

rates. Just as the Phillips curve is derived from a

through the assumption of rational expectations. This

description of the price-setting decisions of business-

assumption simply means that the public—households

es, this other relationship, which describes the

and firms whose decisions drive real economic

demand side of the economy, is based on house-

activity—fully understands how the economy evolves

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over time and how monetary policy shapes that

current inflation is equal to expected inflation. Then,

evolution. It also means that people’s decisions will

whatever that constant rate of inflation, unemploy-

depend on well-informed expectations not only of the

ment must return to the rate implied by the underlying

evolution of future fundamental conditions, but of

structure of the economy, that is, to a rate that might

future policy as well. While discussions of a central

be considered the “natural” unemployment. Money is

bank’s credibility typically assume that there are

not truly neutral in these models, however. Rather,

things related to policymaking about which the public

the pricing frictions underlying the models imply that

is not fully certain, these discussions retain the pre-

there are real economic costs to inflation. Because

sumption that people are forward looking in trying to

sellers of goods adjust their prices at different times,

understand policy and its impact on their decisions.

inflation makes the relative prices of different goods vary, and this distorts sellers’ and buyers’ decisions.

Implications and uses of the modern approach A Phillips curve that is derived as part of a model that

This distortion is greater, the greater the rate of inflation. The expectational nature of the Phillips curve also

includes price-setting frictions is often referred to as

means that policies that have a short-run effect on

the New Keynesian Phillips curve (NKPC).20 A com-

inflation will induce real movements in output or

plete general equilibrium model that incorporates this

unemployment mainly if the short-run movement in

version of the Phillips curve has been referred to as

inflation is not expected to persist. In this sense, the

the New Neoclassical Synthesis

model.21

These

modern Phillips curve also embodies the importance

models, like any economic model, are parsimonious

of monetary policy credibility, since it is credibility that

descriptions of reality. We do not take them as exact

would allow expected inflation to remain stable, even

descriptions of how a modern economy functions.

as inflation fluctuated in the near term.

Rather, we look to them to capture the most important forces at work in determining macroeconomic out-

“ The modern Phillips curve also embodies the

comes. The key equations in new neoclassical or new

importance of monetary policy credibility, since

Keynesian models all involve assumptions or approxi-

it is credibility that would allow expected

mations that simplify the analysis without altering the

inflation to remain stable, even as inflation

fundamental economic forces at work. Such simplifica-

fluctuated in the near term. ”

tions allow the models to be a useful guide to our thinking about the economy and the effects of policy. The modern Phillips curve is similar to the expecta-

A more general way of emphasizing the importance of credibility is to say that the modern Phillips curve

tions-augmented Phillips curve in that inflation expec-

implies that the behavior of inflation will depend

tations are important to the relationship between

crucially on people’s understanding of how the central

current inflation and unemployment. But its derivation

bank is conducting monetary policy. What people

from forward-looking price-setting behavior shifts the

think about the central bank’s objectives and strategy

emphasis to expectations of future inflation. It has

will determine expectations of inflation, especially

implications similar to the long-run neutrality of

over the long run. Uncertainty about these aspects of

money, because if inflation is constant over time, then

policy will cause people to try to make inferences

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about future policy from the actual policy they observe.

in terms of the long-run levels of inflation and unem-

Even if the central bank makes statements about its

ployment they produce, or more generally in terms of

long-run objectives and strategy, people will still try to

the economic well-being generated for people in the

make inferences from the policy actions they see. But

economy. A typical result is that rules that deliver lower

in this case, the inference that people will try to make

and less variable inflation are better both because low

is slightly simpler: people must determine if actual

and stable inflation is a good thing and because such

policy is consistent with the stated objectives.

rules can also deliver less variability in real economic

Does this newest incarnation of the Phillips curve

activity. Further, lower inflation has the benefit of

present a central bank with the opportunity to actively

reducing the costs from distorted relative prices.

manage real economic activity through choosing more

While low inflation is a preferred outcome, it is typi-

or less inflationary policies? The assumption that peo-

cally not possible, in models or in reality, to engineer

ple are forward looking in forming expectations about

a policy that delivers the same low target rate of infla-

future policy and inflation limits the scope for manag-

tion every month or quarter. The economy is hit by

ing real growth or unemployment through Phillips

any number of shocks that can move both real output

curve trade-offs. An attempt to manage such growth

and inflation around from month to month—large

or unemployment persistently would translate into the

energy price movements, for example. In the pres-

public’s expectations of inflation causing the Phillips

ence of such shocks, a good policy might be one that,

curve to shift. This is another characteristic that the

while not hitting its inflation target each month, always

modern approach shares with the older expectations-

tends to move back toward its target and never stray

augmented Phillips curve.

too far.

What this modern framework does allow is the

Complete models incorporating a modern Phillips

analysis of alternative monetary policy rules—that is,

curve also allow economists to formalize the notion

how the central bank sets its nominal interest rate in

of monetary policy credibility. Remember that

response to such economic variables as inflation,

credibility refers to what people believe about the

relative to the central bank’s target, and the unem-

way the central bank intends to conduct policy.

ployment rate or the rate of output growth relative to

If people are uncertain about what rule best

the central bank’s understanding of trend growth.22

describes the behavior of the central bank, then

A typical rule that roughly captures the actual behavior

they will try to learn from what they see the central

of most central banks would state, for instance, that

bank doing. This learning can make people’s

the central bank raises the interest rate when inflation

expectations about future policy evolve in a compli-

is higher than its target and lowers the interest rate

cated way. In general, uncertainty about the central

when unemployment rises. Alternative rules might

bank’s policy, or doubts about its commitment to low

make different assumptions, for instance, about how

inflation, can raise the cost (in terms of output or

much the central bank moves the interest rate in

employment) of reducing inflation. That is, the short-

response to changes in the macroeconomic variables

run relationship between inflation and unemployment

that it is concerned about. The complete model can

depends on the public’s long-run expectations about

then be used to evaluate how different rules perform

monetary policy and inflation.

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The modern approach embodies many features of the earlier thinking about the Phillips curve. The

How Well Does the Modern Phillips Curve Fit the Data?

characterization of policy as a systematic pattern of

The Phillips curve began as a relationship drawn to fit

behavior employed by the central bank, providing

the data. Over time, it has evolved as economists’

the framework within which people form systematic

understanding of the forces driving those data has

expectations about future policy, follows the work of

developed. The interplay between theory—the appli-

Kydland and Prescott. And the focus on expectations

cation of economic logic—and empirical facts has

itself, of course, originated with Friedman. Within

been an important part of this process of discovery.

this modern framework, however, some important

The recognition of the importance of expectations developed together with the evidence of the apparent

“ The short-run relationship between inflation

instability of the short-run trade-off. The modern

and unemployment depends on the public’s

Phillips curve represents an attempt to study the

long-run expectations about monetary policy

behavior of both inflation and real variables using

and inflation. ”

models that incorporate the lessons of Friedman, Phelps, and Lucas and that are rich enough to pro-

debates remain unsettled. While our characterization of the framework has emphasized the forward-looking

duce results that can be compared to real world data. Attempts to fit the modern, or New Keynesian,

nature of people’s expectations, some economists

Phillips curve to the data have come up against a

believe that deviations from this benchmark are

challenging finding. The theory behind the short-run

important for understanding the dynamic behavior of

relationship implies that current inflation should

inflation. We turn to this question in the next section.

depend on current real activity, as measured by

We have described here an approach that has

unemployment or some other real variable, and

been adopted by many contemporary economists

expected future inflation. When estimating such an

for applied central bank policy analysis. But we

equation, economists have often found that an addi-

should note that this approach is not without its

tional variable is necessary to explain the behavior of

critics. Many economists view the price-setting

inflation over time. In particular, these studies find

frictions that are at the core of this approach as

that past inflation is also important.23

ad hoc and unpersuasive. This critique points to the value of a deeper theory of firms’ price-setting

Inflation persistence

behavior. Moreover, there are alternative frictions

The finding that past inflation is important for the

that can also rationalize monetary non-neutrality.

behavior of current and future inflation—that is, the

Alternatives include frictions that limit the information

finding of inflation persistence—implies that move-

available to decisionmakers or that limit some

ments in inflation have persistent effects on future

people’s participation in some markets. So while

inflation, apart from any effects on unemployment or

the approach we’ve described does not represent

expected inflation. Such persistence, if it were an

the only possible modern model, it has become a

inherent part of the structure and dynamics of the

popular workhorse in policy research.

economy, would create a challenge for policymakers

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to reduce inflation by reducing people’s expectations.

result of the nature of the shocks hitting the economy.

Remember that we stated earlier the possibility that if

If these shocks are themselves persistent—that is,

the central bank could convince the public that it was

bad shocks tend to be followed by more bad

going to bring inflation down, then the desired reduc-

shocks—then that persistence can lead to persist-

tion might be achieved with little cost in unemploy-

ence in inflation. The way to assess the relative

ment or output. Inherent inflation persistence would

importance of alternative possible sources of persist-

make such a strategy problematic. Inherent persist-

ence is to estimate the multiple equations that make

ence makes the set of choices faced by the policy-

up a more complete model of the economy. This

maker closer to that originally envisioned by

approach, in contrast with the estimation of a single

Samuelson and Solow. The faster one tries to bring

Phillips curve equation, allows for explicitly consider-

down inflation, the greater the real economic costs.

ing the roles of changing monetary policy, backward-

Inherent persistence in inflation might be thought to

looking pricing behavior, and shocks in generating

arise if not all price-setters in the economy were as

inflation persistence. A typical finding is that the back-

forward looking as in the description given earlier. If,

ward-looking terms in the hybrid Phillips curve appear

instead of basing their price decisions on their best

considerably less important for explaining the dynam-

forecast of future inflation behavior, some firms simply

ics of inflation than in single equation estimation.26

based current price choices on the past behavior of

The scientific debate on the short-run relationship

inflation, this backward-looking pricing would impart

between inflation and real economic activity has not

persistence to inflation. Jordi Galí and Mark Gertler,

yet been fully resolved. On the central question of the

who took into account the possibility that the economy

importance of backward-looking behavior, common

is populated by a combination of forward-looking and

sense suggests that there are certainly people in the

backward-looking participants, introduced a hybrid

real-world economy who behave that way. Not every-

Phillips curve in which current inflation depends on

one stays up-to-date enough on economic conditions

both expected future inflation and past inflation.24

to make sophisticated, forward-looking decisions.

An alternative explanation for inflation persistence

People who do not may well resort to rules of thumb

is that it is a result primarily of the conduct of mone-

that resemble the backward-looking behavior in some

tary policy. The evolution of people’s inflation ex-

economic models. On the other hand, people’s

pectations depends on the evolution of the conduct of

behavior is bound to be affected by what they believe

policy. If there are significant and persistent shifts in

to be the prevailing rate of inflation. Market partici-

policy conduct, expectations will evolve as people

pants have ample incentive and ability to anticipate

learn about the changes. In this explanation, inflation

the likely direction of change in the economy. So both

persistence is not the result of backward-looking

backward- and forward-looking behavior are ground-

decisionmakers in the economy but is instead the

ed in common sense. However the more important

result of the interaction of changing policy behavior

scientific questions involve the extent to which either

and forward-looking private decisions by households

type of behavior drives the dynamics of inflation and

and businesses.25

is therefore important for thinking about the conse-

Another possibility is that inflation persistence is the

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The importance of inflation persistence for policymakers

back down after a number of FOMC members made

Related to the question of whether forward- or back-

inflation. This episode illustrates both the potential

ward-looking behavior drives inflation dynamics is the

for the Fed to influence inflation expectations and

question of how stable people’s inflation expectations

the extent to which market participants are at times

are. The backward-looking characterization suggests

uncertain as to how the Fed will respond to

a stickiness in beliefs, implying that it would be hard

new developments.

speeches emphasizing their focus on preserving low

to induce people to change their expectations. If relatively high inflation expectations become ingrained,

Making Policy

then it would be difficult to get people to expect a

While the scientific dialogue continues, policymakers

decline in inflation. This describes a situation in which

must make judgments based on their understanding

disinflation could be very costly, since only persistent

of the state of the debate. At the Federal Reserve

evidence of changes in actual inflation would move

Bank of Richmond, policy opinions and recommenda-

future expectations. Evidence discussed earlier from

tions have long been guided by a view that the short-

episodes of dramatic changes in the conduct of policy,

term costs of reducing inflation depend on expecta-

however, suggests that people can be convinced that

tions. This view implies that central bank credibility—

policy has changed. In a sense, the trade-offs faced

that is, the public’s level of confidence about the central

by a policymaker could depend on the extent to which

bank’s future patterns of behavior—is an important

people’s expectations are subject to change. If people

aspect of policymaking. Central bank credibility

are uncertain and actively seeking to learn about the

makes it less costly to return inflation to a desirable

central bank’s approach to policy, then expectations

level after it has been pushed up (or down) by energy

might move around in a way that departs from the

prices or other shocks to the economy. This view of

very persistent, backward-looking characterization.

policy is consistent with a view of the Phillips curve in

But this movement in expectations would depend on

which inflation persistence is primarily a consequence

the central bank’s actions and statements about its

of the conduct of policy.

conduct of policy.

The evidence is perhaps not yet definitive. As out-

The periods that Goodfriend (1993) described as

lined in our argument, however, we do find support

inflation scares can be seen as periods when people’s

for our view in the broad contours of the history of

assessment of likely future policy was changing

U.S. inflation over the last several decades. At a time

rather fluidly. Even very recently, we have seen

when a consensus developed in the economics

episodes that could be described as “mini scares.”

profession that the Phillips curve trade-off could be

For instance, in the wake of Hurricane Katrina in late

exploited by policymakers, apparent attempts to do

2005, markets’ immediate response to rising energy

so led to or contributed to the decidedly unsatisfactory

prices suggested expectations of persistently rising

economic performance of the 1970s. And the

inflation. Market participants, it seems, were uncer-

improved performance that followed coincided with

tain as to how much of a run-up in general inflation

the solidification of the profession’s understanding of

the Fed would allow. Inflation expectations moved

the role of expectations. We also see the initial costs

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of bringing down inflation in the early 1980s as

There are also, we think, important lessons in the

consistent with our emphasis on expectations and

observation that overall economic performance, in

credibility. After the experience of the 1970s, credibili-

terms of both real economic activity and inflation, was

ty was low, and expectations responded slowly to the

much improved beginning in the 1980s as compared

Fed’s disinflationary policy actions. Still, the response

to that in the preceding decade. While this improve-

of expectations was faster than might be implied by a

ment could have some external sources related to the

backward-looking Phillips curve.

kinds of shocks that affect the economy, it is also

We also view policymaking on the basis of a

likely that improved conduct of monetary policy

forward-looking understanding of the Phillips curve

played a role. In particular, monetary policy was able

as a prudent approach. A hybrid Phillips curve with

to persistently lower inflation by responding more to

a backward-looking component presents greater

signs of rising inflation or inflation expectations than

opportunities for exploiting the short-run trade-off.

had been the case in the past. At the same time, the

In a sense, it assumes that the monetary policymaker

variability of inflation fell, while fluctuations in output

has more influence over real economic activity than

and unemployment were also moderating.

is assumed by the purely forward-looking specification. Basing policy on a backward-looking formulation

“ An approach to policy that is able to stabilize

would also risk underestimating the extent to which

expectations will be most able to maintain low

movements in inflation can generate shifts in inflation

and stable inflation with minimal effects on real

expectations, which could work against the policy-

activity. ”

maker’s intentions. Again, the experience of past decades suggests the risks associated with policy-

We think the observed behavior of policy and

making under the assumption that policy can

economic performance is directly linked to the

persistently influence real activity more than it really

lessons from the history of the Phillips curve. Both

can. In our view, these risks point to the importance

point to the importance of the expectational con-

of a policy that makes expectational stability

sequences of monetary policy choices. An approach

its centerpiece.

to policy that is able to stabilize expectations will be most able to maintain low and stable inflation with

Conclusion

minimal effects on real activity. It is the credible main-

One key lesson from the history of the relationship

tenance of price stability that will in turn allow real

between inflation and real activity is that any short-run

economic performance to achieve its potential over

trade-off depends on people’s expectations for infla-

the long run. This will not eliminate the business cycle

tion. Ultimately, monetary policy has its greatest

since the economy will still be subject to shocks that

impact on real activity when it deviates from people’s

quicken or slow growth. We believe the history of the

expectations. But if a central bank tries to deviate

Phillips curve shows that monetary policy’s ability to

from people’s expectations repeatedly, so as to sys-

add to economic variability by overreacting to shocks

tematically increase real output growth, people’s

is greater than its ability to reduce real variability,

expectations will adjust.

once it has achieved credibility for low inflation.

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Endnotes 1. King and Plosser (1984).

14. Sargent (1986).

2. Cooley and Hansen (1989), for instance.

15. Goodfriend and King (2005).

3. Phillips (1958).

16. Ibid.

4. Keynes (1923).

17. Mankiw (2007).

5. Samuelson and Solow (1960).

18. Goodfriend (1993).

6. Ibid., p. 193. 7. Friedman (1968), p. 5.

19. There are a number of technical assumptions needed to make this intuitive connection precisely correct.

8. Phelps (1967).

20. Clarida, Galí, and Gertler (1999).

9. Lucas (1972).

21. Goodfriend and King (1997).

10. Velde (2004) provides an excellent overview of this debate. A nontechnical description of the major arguments can be found in Sumo (2007).

22. We use the term “monetary policy rule” in the very general sense of any systematic pattern of choice for the policy instrument—the funds rate—based on the state of the economy.

11. Lucas (1976).

23. Fuhrer (1997).

12. Kydland and Prescott (1977).

24. Galí and Gertler (1999).

13. Sargent (1999), Cogley and Sargent (2005), and Sargent, Williams, and Zha (2006).

25. Dotsey (2002) and Sbordone (2006). 26. Lubik and Schorfheide (2004).

References Clarida, Richard, Jordi Galí, and Mark Gertler. 1999. “The Science of Monetary Policy: A New Keynesian Perspective.” Journal of Economic Literature 37 (4): 1661-1707.

Lubik, Thomas A., and Frank Schorfheide. 2004. “Testing for Indeterminacy: An Application to U.S. Monetary Policy.” American Economic Review 94 (1): 190-217.

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